So what determines the price of a stock? If a stock’s earnings are predictably growing and a stock will be making 20% higher earnings four years later, why doesn’t the stock just increase in value by 20% immediately? As I’ve said before, one cannot take advantage of news for near-term trading because as soon as the news is released, it is already priced into the stock. So why is this not true of the long-term.
The reason is that the future earnings, while often predictable, are not known for certain. There is risk and uncertainty involved. When one buys a stock, while one may believe that the earnings will increase and the stock price increase accordingly (because the stock would then be able to pay a bigger dividend), one does not know for certain. It is not like putting money in a bank account with a fixed interest rate. In the case of the bank, the interest will almost certainly be paid. If it isn’t, one can sue the bank or the Federal Government may even make the payment. With stocks, one cannot sue if earnings do not grow as expected, or even if the stock price drops and one loses money.
The rate of return of any asset, be it a bank account, bond, stock, or real estate will be based on the risk involved. The more risk involved, the greater return individuals will expect to receive before they will take the risk. Because bank accounts offer a way to safely store money, individuals will put money in even though they lose a couple of percentage points to inflation each year. Before a person will buy a stock, the possible return, measured by dividends paid currently and price appreciation potential, must be large enough to justify the risk. If stocks did not return several percentage points better than a bank account, why would anyone not just keep their money in the bank for the certain return? They wouldn’t!
So, the price of a stock is based upon current earnings and current dividends (if any are paid), earnings growth rate (how large a dividend is likely to be paid in the future), and the perceived level of risk to the share price due to various factors and the predictability of the earnings growth. If the predicted earnings growth rate for a stock is about 10% and there is good certainty that the company will meet expected earnings, the price of the stock may increase until the effective rate of return for new investors in the stock (based on predicted earnings) is about 8% per year if bank account interest rates are around 2%. This means that investors are willing to take the increased risk of investing in the stock as long as they get at least 6% better return then they would get in the bank. If bank interest rates increase, the price of the stock would drop until the rate of return was again about 6% greater than that of the bank.
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If uncertainty of earnings increased, for example if a stock that had been producing steadily growing earnings entered a period where earnings were unpredictable, the stock price would drop until the rate of return was higher, perhaps 8% or 10% higher than that of a bank account. Because an investor in the company now is less likely to actually get the 6% return, he will not invest unless the stock price is low enough that he will receive 8% if things do work out. Note that this is why companies see the price of their shares drop when uncertainty increased, such as when Congress is proposing legislation that may affect their business or a lawsuit is pending. The uncertainty makes it more difficult to predict future earnings, so people expect a higher possible return. When the event actually happens, even if it ends up being detrimental to the company, the price usually increased when the news comes out because the uncertainty has been erased and investors can start to more easily predict future earnings.
So, this all means that if one picks companies that have fairly reliable long-term earnings growth trends, one can expect to generate a good investment return. Even though the fact that earnings will probably grow is known by everyone, the full effect of the future earnings is not instantly priced into the price of the shares, as it is with near-term investing. So, a serious investor, who really wants to make money, will take the long-term road. The person who jumps in and out of stocks is just playing around and eventually the odds will catch up with him.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.